Rate cut leads to stormy conditions for cash investors

The safety margin of cash as an income-generating investment has been reduced by the past week’s interest rate cut, once again forcing investors to rethink wealth creation strategies.

The Reserve Bank of Australia’s 0.25 percentage point reduction in the official rate to 3 per cent will make cash returns even less attractive than most potentially capital-increasing – and -decreasing – alternatives such as property and shares. On yield alone, an average 5 per cent is predicted from the sharemarket in 2013, with about 3 per cent forecast earnings growth.

Picking the right investment property may generate a yield of about 4.5 per cent, with potential capital growth over the longer term.

The best one-year term deposit rate for $100,000 is 4.75 per cent, says comparison website Canstar, and the highest paying savings account is about 5.35 per cent – with conditions.

Depending on ongoing funding requirements, the official rate cut suggests banks will further reduce deposit rates to improve margins.

Prescott Securities chief economist Darryl Gobbett says the RBA would like to see home loan and term deposit rates fall further to boost the economy. Gobbett believes it could take another official rate cut and a reduction in term deposits to closer to 4 per cent to get investors really thinking about whether cash is the best place to be.

The RBA move leaves those investors with capital parked in cash – hoping to avoid the volatility of equities and in need of income – with some big decisions.

While the government may guarantee cash deposits with any of he approved deposit-taking institutions, lower cash rates combined with tax and inflation can be a poor combination for good returns.

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The latest cut takes the rate to a global financial crisis low, equal to the lowest since the RBA began publishing its official rates in 1990, and is only just ahead of the official inflation rate of about 2.5 per cent. With rising costs across the board, investors may have to reduce their capital reserves to fund their cost of living.

Alternative income-generating investments include property and shares but both rely on a strong economy and consumer confidence to keep them buoyant.

A key reason for the RBA to cut rates is to push investors into these other asset classes, says NAB Private Wealth investment strategist Nick Ryder. “Over the longer term these asset classes do go up and people start to feel wealthier, and that helps with confidence," he says.

For those prepared to take on extra risk, exiting cash may make sense. But for the nearly or already retired, capital preservation is key.

Ryder says cash remains the preferred defensive asset. Rising competition among banks for consumer deposits means returns are still ahead of the most defensive asset – government bonds.

The 10-year government bond rate is 3.15 per cent, while the five-year and three-year rates are below the cash rate at 2.68 per cent and 2.6 per cent respectively.

Offering more risk but paying higher yields are corporate bonds and then hybrid securities, which offer higher yields but are exposed to the sharemarket.

Ipac Western Australia partner and senior adviser John Donald says that the GFC is still fresh in many people’s minds of many and there are still concerns over the state of the European and US economies, so there is still a comfort factor in bank accounts and term deposits, even if returns are lower.

“There is still a large amount of cash held in bank accounts and a significant reason is more about the comfort investors have that their capital is ‘safe’ rather than using this asset class to generate a source of medium- to longer-term income returns," Donald says.

“I am finding people remain nervous, particularly as the US confronts its ‘fiscal cliff’ in January. I still believe some investors are fearful of the impact that any negative outcome in the US budget negotiations would have on a still fragile world economy and investment markets."

Given significant risks remain, it is prudent to keep a reasonable level of cash as protection against further volatility, he says, but it may also be time to stage moving away from cash.

Where someone invests will depend on their life stage and their return objectives. Someone wanting to grow capital aggressively will look for different investments than those requiring income.

Younger people not too far into their working lives and still accumulating wealth generally need growth and have time on their side.

Resi Mortgage Corporation chief executive Lisa Montgomery says there was a surge in property sales in early spring after earlier rate cuts, although markets vary widely across the county.

Borrowers are still conservative. Those with existing mortgages favour paying off their loans over the purchase of consumer goods. Investors Mortgage senior mortgage broker Amit Sharma says a good investment property delivers a return of 4.5 per cent or more, which is now achievable. He feels investors will start to shift cash to property.

“There is no better investment than in a property that gives you money in your pocket after expenses," Sharma says. “This is exactly what could happen if property prices stay where they are and interest rates keep going down."

One major bank is offering a savings rate of 5 per cent and the best variable home loan interest rate by a major bank (a no-frills loan) is 5.73 per cent.

“After this latest rate cut there is not much to choose between the two options and it may be better to invest in property and achieve higher rental returns than stashing money away in the bank," Sharma says.

Of course the other part of an investment property is the rental return. Sharma says history shows when the availability or cost of finance is pushed down, house prices come in reach of prospective first-home buyers and rents stabilise or fall as more people move from rental properties to purchasing homes.

But rent tends to play catch-up to capital gains, Sharma says.

“We saw rental growth in 2011 and the beginning of 2012, before stabilising in 2012," he says.

“Today, investors are sitting on the sidelines due to economic fears from overseas and interest rate uncertainty here in Australia. If investors are not buying today, then they will be forced to pay higher property prices tomorrow."

Prescott’s Gobbett expects the early interest in property to be at the low end, such as easy to rent apartments and cheaper housing.

“Equities look OK if you have a five- to 10-year time horizon but don’t expect huge growth in the near term," Ryder says.

“The earnings growth forecast for the ASX 200 is 3 per cent next year. The market dividend yield is forecast to be in the low 5 per cent range, with another 1 per cent for franking credits. That is not bad from an income perspective."

Ryder suggests investors cautiously start to get back into quality cyclical companies rather than high-priced defensive stocks, many of which have had their prices pushed up due to the high dividends they have been paying.

UBS Wealth Management head of investment strategy and consulting George Boubouras recommends a combination of quality defensives with a dividend strategy for conservative portfolios through to increased exposure to cyclicals for a more aggressive risk appetite.

For global equities, the focus is on quality earnings diversification. But locally, income will remain “a key part" of expected returns. “Equity valuations remain compelling on most measures," says Boubouras.

If the objective is to produce a steady, tax-effective income stream, good quality Australian shares with a long history of paying dividends are a real alternative to a term deposit, says ipac’s Donald.

“Some current yields are very attractive and if you then add the franking credit, you are looking at a nice, tidy return," he says.

He adds this strategy requires investors to be comfortable with short-term volatility as their capital will still vary. But by focusing on quality and targeting companies with high dividends, investors may also experience less volatility as typically many are defensive stocks.

“Some listed property trusts that have a sound record of paying income may also be considered," Donald says.

“And I would also be looking at managed fund options that focus on tax-effective income generation but also have exposure to growth assets to cover against inflation."